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Small Business Financial Management Kit FORDUMmIES‰by Tage C. Tracy, CPA and John A. Tracy, CPA Small Business F. Creativity Connection of the Arts and Business Council of Americans for the on more than 30 other books, including Managing For Dummies, 2nd Ed., The. Contents. 4. CONTENTS. The Basics of Business Management – Vol. I: Leadership, Financial. Management and Economics. Part I: Leaders And Managers. 7. 1.

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Business Process Management For Dummies®, 3rd IBM Limited Edition. Published by. John Wiley & Sons, Inc. River St. Hoboken, NJ four books (The Brass Tacks Entrepreneur, Small Business Management find out why readers Small Starting an Online Business For Dummies, 6th Edition. has also been referenced by the PCI Council in their Data Security Standard Wireless Katalov Hacking For Dummies Fitness For Dummies 3rd Edition.

In the example, the business increases its shortterm and long-term debt during the year, which are positive cash flows. Total current assets less total current liabilities equals the net working capital of a business. Where to Go from Here You may want to start with Chapter 1 and proceed through the chapters in order. Once the die is cast — in other words, after you have decided on which specific accounting methods to adopt — you have to stick with these methods year after year. Liquidity and Business Solvency To truly understand if a business is solvent, the concept of liquidity must be addressed simultaneously.

Creating an Engaged Workforce. Part II: Mastering Key Management Duties. Chapter 5: The Million-Dollar Decision. Chapter 6: Goal Setting Made Easy. Chapter 7: Developing Employees through Coaching and Mentoring.

Chapter 8: It's a Team Thing. Chapter 9: Managing Virtual Employees. Chapter Monitoring Performance and Execution. Part III: Tools and Techniques for Managing. Delegating to Get Things Done. Communicating Your Message. The Fine Art of Performance Evaluations. Budgeting, Accounting, and Other Financial Stuff. Harnessing the Power of Technology. Embracing Corporate Social Responsibility and Ethics.

Part IV: Tough Times for Tough Managers. Managing Change and Morale. Employee Discipline for Improving Performance. Part V: The Part of Tens. Ten Common Management Mistakes. Keeping Your Business Solvent Using Tools of the Trade Protecting the Family Jewels Scrutinizing Your Costs Practical Budgeting Techniques for Your Business Making Decisions with a Profit Model Dealing with Small Business Financial Issues Jumping Through Tax Hoops Raising Capital for Your Business Diagnosing Your Financial Condition Looking at Service and Manufacturing Businesses When You Sell Services Reaching the End of the Line The Part of Tens About the CD Managing Your Small Business Finances.

Keeping Your Business Solvent. Protecting the Family Jewels. Scrutinizing Your Costs. Practical Budgeting Techniques for Your Business. Making Decisions with a Profit Model. Productivity Gains Versus Cutting Quality Jumping Through Tax Hoops.

Raising Capital for Your Business. Diagnosing Your Financial Condition. When You Sell Services. About the CD. They have a good overall business model and they manage other aspects of their business fairly well. But when you start talking about financial topics, they get sweaty palms. They do little more than keep tabs on their cash balance. This book, quite simply, explains the fundamentals of small business financial management. We explain the accounting reports — which are called financial statements or just financials — you need to understand in running your business.

We discuss many other critical financial management topics, including raising capital, making smart profit decisions, and choosing the best form of legal entity for income tax. About This Book Business managers are busy people, and they have to carefully budget their time. We promise not to waste your time in reading this book. In every chapter, we cut to the chase.

We contain our discussions to fundamentals — topics you must know to handle the financial affairs of your business. This book is not like a mystery novel; you can read the chapters in any order. Each chapter stands on its own feet. You may have more interest in one chapter than others, so you can begin with the chapters that have highest priority to you.

Where a topic overlaps with a topic in another chapter, we provide a cross-reference. By all means, use the book as a reference manual. Put the book on your desk and refer to it as the need arises. The only test is whether you improve your skills for managing the financial affairs of your business.

Many chapters use figures to demonstrate the financial statements that you work with in managing the financial affairs of your business. We explain what these financial statements mean and how to interpret the information.

The examples are as realistic as we can make them without getting bogged down in too many details. The examples are not theoretical; the examples are from the real world. In preparing financial statements, your accountant conforms to the standardized formats and terminology adopted by the accounting profession. In other words, your accountant adheres to the established protocols for presenting financial statements. These rules are the grammar for communicating information in financial statements.

However, accounting comes across as a foreign language to many business managers, and we keep this point in mind on every page of the book. In Chapter 1, we begin by explaining the communication conventions of financial statements.

Speaking of accountants, we should distinguish between the internal accountant, who is an employee of your business, and the outside, independent accounting professional who advises you from time to time. A small business employs an accountant who is in charge of its accounting system. In this book, the term accountant refers to the person on your payroll. We refer to your independent professional accountant as a CPA certified public accountant.

You should refer the more technical aspects to your accountant and make sure that the accountant follows through on the assignment. A good example is Chapter 5 on internal controls, which refer to the procedures put in place to minimize errors and fraud. You should definitely understand the critical need for establishing and enforcing effective controls.

But the implementation of internal controls is a job for your accountant. But we have a good composite profile of you based on our experience in consulting with small business managers and explaining financial issues to business managers who have a limited background in financial matters.

We take nothing for granted and start our discussions at ground zero. We present the material from the ground level up. The more you already know about the topics, the quicker you can move through the discussion. If nothing else, the book is a checklist of the things you ought to know for managing the finances of a small business. The following sections describe what you find in each part. Part I: Improving Your Profit, Cash Flow, and Solvency In keeping your small business thriving and growing you encounter three financial imperatives: You receive a financial statement for each imperative.

Part I explains these three financial statements and how to use this information for making a profit and controlling the cash flow and financial condition of your business. It explores internal controls that minimize accounting errors and threats of fraud from within and without your business, as well as cost control, which goes beyond the simplistic notion of just minimizing costs.

This part also covers practical budgeting and planning techniques for the small business and how to develop and use a profit model for decision-making analysis. Part III: Dealing with Small Business Financial Issues In starting a business, the founders have to decide which type of legal entity to use.

This part explains the alternative legal entities for carrying on business activities and what you should consider from the income tax point of view when you structure your business. This part also offers practical advice on how to raise the capital you need for your business. Part IV: Looking at Service and Manufacturing Businesses Part IV describes services businesses and how they differ from businesses that sell products, as well as how manufacturing businesses determine their product cost.

Although you may not be a service business or a manufacturer, you can gain insights from this part. Part V: Reaching the End of the Line This part of the book has a special place in our hearts — not because we want you to go out of business, of course. But there may come a time when a successful business wants to cash in its chips and leave the game.

You probably know of several entrepreneurs who decided to sell out and move on to new challenges. This part presents a concise explanation of small business valuation methods. It also walks you through the steps of liquidating assets, paying liabilities, and making final distributions to owners assuming that some money is left after paying liabilities and the lawyers.

Introduction Part VI: These chapters offer pithy lists of advice that sum up the main points explained in the chapters. One chapter offers general management rules for the small business.

First and foremost, you must be a good manager to make your small business venture a success. The second chapter focuses on ten important financial management rules and techniques. We prepared all examples using the Excel spreadsheet program from Microsoft.

You can use each example on the CD as a template, or pattern for your business situation or to explore alternative scenarios. For example, you can quickly analyze what would happen to profit if sales volume had been 10 percent higher or lower than in the example.

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To use the template for your business you need to replace the data in the example with the data for your business situation. You would probably assign this data entry process to your accountant, who should find the templates very useful.

Your accountant can easily expand or modify the template to fit the particular circumstances of your business. The books use financial statement examples that were prepared using Excel. John offers to e-mail the Excel worksheets to the reader. Literally hundreds and hundreds of readers have asked for the Excel worksheets.

We thought it would be more convenient to provide the worksheets on the CD for this book. This book and its CD constitute an integrated kit. Icons Used in This Book Throughout this book, you see some little pictures in the margin. These icons highlight the following types of information: Each worksheet example is prepared as a template. You can open the figure with the Excel spreadsheet program and follow along on your computer screen each step in the explanation.

This makes the explanation more live and real time. You can also change the data in the example to simulate outcomes for alternative scenarios, which is an effective learning method.

This icon asks you to keep in mind an important point that is central in the explanation of the topic at hand. This icon highlights, well, tips for applying financial management techniques. On second thought, this icon saves you the cost of buying a highlighter pen.

This sign warns you about speed bumps and potholes on the financial highway. Taking special note of this material can steer you around a financial road hazard and keep you from blowing a fiscal tire. You can save yourself a lot of trouble by paying attention to these warning signs.

Where to Go from Here You may want to start with Chapter 1 and proceed through the chapters in order. If your highest priority concerns are about income tax issues, you can jump into Chapter 9 right away.

If you worry about fraud threats against your business, Chapter 5 is a good place to start. Starting and managing a small business is a tremendously challenging undertaking, and we applaud you. You have a lot of guts. And you also need a lot of financial management savvy. We hope our book helps you succeed. Financial statements are the main source of information for carrying out your financial management functions.

So, we carefully explain the conventions and customs accountants use in preparing financial statements. The three primary financial imperatives of every business are to make profit, generate cash flow from making profit which is not the same as making profit , and control financial condition and solvency. Accordingly, a separate financial statement is prepared for each purpose.

We explain these three primary financial statements. You have to be good at sales and marketing. You have to be knowledgeable about hiring, training, and motivating employees. You have to understand production systems if you are in the manufacturing business. You have to be smart at purchasing. You should be aware of business law and government regulations. You have to figure out where you have an edge on your competitors. Equally important, you need good skills for managing the financial affairs of your business.

Identifying Financial Management Functions Managing the finances of a small business is not just doing one or two things. Financial management is broader than you might think — it involves a palette of functions: In the meantime these responsibilities fall in your lap, so you better know how to manage the financial affairs of your business.

The failure rate of new businesses is high. Many entrepreneurs would like to think that if they have a good business model, boundless enthusiasm, and work tirelessly they are sure to succeed. The evidence speaks otherwise. To press home our point we ask an embarrassing question: Are you really on top of the financial functions that keep your business on course and out of trouble for achieving your financial objectives?

Our book helps you to answer yes to these questions. We could beat around the bush and suggest that you might be able to get along with only a minimal grasp on your financial statements.

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This would be a risky strategy, however. Check with Tage, the coauthor of this book, regarding his hourly rate for advising small business clients. Chapter 1: Managing Your Small Business Finances Financial statements are prepared according to established, or one could say entrenched conventions.

Uniform styles and formats for reporting financial statements have evolved over the years and become generally accepted. The conventions for financial statement reporting can be compared to the design rules for highway signs and traffic signals. Without standardization there would be a lot of accidents. It would be confusing if each business made up its own practices for presenting its financial statements. If your financial statements did not abide by these rules they would look suspect to your lenders, owners, and anyone else who sees the financials.

They might question whether your accountant is competent. We present many financial statements and accounting reports throughout the book. Therefore, at this early point in the book we explain the communication styles and conventions of financial statements.

This business example is organized as a pass-through entity for income tax purposes and, therefore, does not itself pay income tax. We discuss pass-through entities in Chapter 9. Sales revenue is listed first, which is the gross total income from the sale of products and services before any expenses are deducted. If the main revenue stream of the business is from selling products the first expense deducted from sales revenue is cost of goods sold, as in this example.

Improving Your Profit, Cash Flow, and Solvency Deducting cost of goods sold expense from sales revenue gives gross margin also called gross profit. Before interest expense is deducted the standard practice is to show operating profit also called operating earnings , which is profit before interest expense.

Some financial statements display all figures in a single column. Or, the accountant who prepared the financial statement may assume that you know that expenses are deducted from sales revenue, so no parentheses are put around the number.

In the illustration all amounts are have a dollar sign prefix. However, financial reporting practices vary quite a bit on this matter. This means that the expense amount is being subtracted from sales revenue. The number below the underline, therefore, is a calculated amount. Trying to read down a column of numbers that are not right aligned would be asking too much; the reader might develop vertigo reading down a jagged column of numbers.

Really big businesses round off to the nearest million, and drop the last six digits. However, this gives a false sense of precision. Accounting for business transactions cannot be accurate down to the last dollar; this is nonsense. A well-known economist Chapter 1: Managing Your Small Business Finances once quipped that accountants would rather be precisely wrong than approximately correct. This is about as carried away as accountants get in their work — a double underline.

Instead of a double underline for a bottom-line number, it may appear in bold. The accounting terminology in financial statements is mixed bag. Many terms are straightforward. If you have business experience you should understand most terms. Nevertheless, we must admit that accountants use jargon more than they should. In some situations accountants resort to arcane terminology to be technically correct, like language used by lawyers in filing lawsuits and drawing up contracts. Your accountant should prepare financial statements that are as jargon-free as possible.

Where we have to use jargon in the book we pause and clarify what the terms mean in plain English. See Chapter 6 13 14 Part I: You need to make a steady profit to survive and thrive. The evidence suggests just the opposite. They generally know that profit information comes out of their accounting system.

A quick peek at the bottom line is no way for keeping your business profitable and growing your business. A good part of this chapter explains this profit performance financial statement. You should thoroughly understand this accounting report. You have to read the newspaper to learn the news. In this chapter, we concentrate on the fundamentals of profit accounting and the basic design of the financial statement that reports your profit performance.

Periodic means for a period of time, which can be one calendar quarter three months , one year, or some other stretch of time. These days, a business manager may want it displayed on his computer screen. Your Controller is the profit and loss scorekeeper for your business, although managers generally have a lot to say regarding the methods and estimates used to measure profit and loss.

Your business sells products, which are also known as goods or merchandise. Your basic business model is to sell a volume of products at adequate markups over their costs to cover operating expenses so that you generate a satisfactory profit after your interest and income tax expenses.

As a matter of fact, this basic business model fits a wide variety of businesses that sell products — from Wal-Mart to your local bookstore or shoe store. Chapter 2: Sales revenue Cost of goods sold expense Gross margin Operating expenses: You and your accountant can use these templates for your business situation.

Basically, the spreadsheet template provides a quick means to simulate profit under different conditions. We include the source column in Figure to call your attention to where the dollar amounts come from. For example, the business keeps several accounts for recording sales revenue. This important number is also called gross profit. In the source column, you see not applicable. The business is organized legally as a so-called pass-through entity.

We explain different legal types of business entities in Chapter 9. GAAP stands for generally accepted accounting principles. GAAP refers to the body of authoritative accounting and financial reporting standards that has been established by the accounting profession over many years.

In short, these accounting standards should be used by all businesses no matter their size. Unless a financial statement makes clear that different accounting methods are being used, the reader is entitled to assume that GAAP are used to measure profit and to present financial condition.

You should assume that the business is using accrual-basis accounting, not a cash-basis method. The first step in your business model is to sell a lot of products at adequate markups over their costs. This amount is called gross margin or gross profit. Gross margin equals profit before other expenses are taken into account. In accounting, the word gross simply means before other expenses are deducted. Indeed, your profit or loss depends on the size of the other expenses: Even a fairly small business keeps more than expense accounts.

In filing its annual federal income tax return, a business has to Chapter 2: Of course, a business should keep these basic expense accounts. In Figure , we show four operating expense lines below the gross margin profit line. Operating expenses encompass the various costs of running a business.

Many small businesses have substantial advertising and other sales promotion costs. The cost of using its long-term operating assets building, machines, trucks, and equipment is recorded as depreciation expense. This measure of profit is also called operating earnings or earnings before interest and income tax. A business may be organized as an entity that is subject to paying federal income tax. Interest is deductible to determine annual taxable income just like other business expenses.

Thus, it makes sense to put income tax expense below the interest expense line. Instead, this type of business entity passes through its taxable income for the year to its owners.

In the example shown in Figure , the business is a pass-through tax entity, so it has no income tax expense. Until sold, the cost of products is recorded in an asset account called inventory. This is one basic element of accrualbasis accounting. Accrual-basis accounting can be viewed as economic reality accounting.

Businesses that sell products and hold an inventory of products awaiting sale , sell on credit, make purchases on credit, and own long-lived operating assets buildings, trucks, tools, equipment, and so on use accrual-basis accounting to measure their profit and to record their assets and liabilities. Basically, accrual-basis accounting recognizes the assets and liabilities of selling and buying on credit and spreads the cost of long-term operating assets over the years of their useful lives, which is called depreciation.

It is also called net earnings, or just earnings. The term profit is generally avoided. So, the business model was executed successfully: This question crosses the border from the accounting function to the financial management function.

Accountants provide information; managers interpret and judge the information and take action for the future. For example, they think sales revenue equals cash inflow from customers during the period. In addition to the confusion over the cash flows of revenue and expenses, small business managers should be aware of several other issues, outlined in the following sections, in measuring and reporting profit.

Most are arbitrary and subjective to some degree. For one example, a business has to estimate the useful lives of its fixed, or long-term, operating assets in order to record depreciation expense each year. Predicting useful lives of fixed assets is notoriously difficult and ends up being fairly arbitrary. At the end of the year, a business may have to record an expense caused by the loss in value of its inventory because some of its products will have to be sold at a price below cost, or the products may not be salable at all.

Determining the loss in inventory value is notoriously difficult. Inventory write-down is subject to abuse by businesses that want to minimize their taxable income for the year. The reliability of your accounting system depends first of all on hiring a competent accountant to put in charge of your accounting system. Bigger businesses have an advantage on this score. They hire more experienced and generally more qualified accountants. We recommend that you hire a trained and competent accountant to put in charge of your accounting system.

This person is typically given the title Controller, assuming that she has adequate accounting education and experience. To save money, many small businesses hire a bookkeeper who knows recordkeeping procedures but whose accounting knowledge is limited.

If you employ a bookkeeper instead of a better educated and more experienced accountant , you should consider using an independent CPA to periodically review your accounting system. Improving Your Profit, Cash Flow, and Solvency Additionally, every business should enforce internal accounting controls to prevent or at least minimize errors and fraud.

We explain these important controls in Chapter 5. As a practical matter, errors can and do sneak into accounting records, and employees or others may have committed fraud against the business. In order to conceal theft or embezzlement, they prevent the recording of the loss in your accounting records. Ideally your accounting system should capture and record all your transactions completely, accurately, and in a timely manner.

Furthermore, any losses from fraud and theft should be rooted out and recorded. You have to be vigilant about the integrity of your accounting records. Our advice is to avoid taking your accounting records for granted; use good internal accounting controls; and be ever alert for possible fraud. Trust, but verify. Someone needs to select the accounting methods for recording revenue and expenses Sales revenue can be recorded sooner or later, and likewise expenses can be recorded sooner or later.

Some accounting methods record revenue and expenses as soon as possible; alternative methods record these profit transactions as late as possible. Remember that profit is a periodic measure. Expenses for the period are deducted from sales revenue for the period to measure profit for the period.

This state of affairs is like having different speed limits for a highway. How fast do you want to drive? In short, accounting standards permit different methods regarding when to record revenue and expenses. Take cost of goods sold expense, for example one of the largest expenses of businesses that sell products. You can use three alternative, but equally acceptable, methods. Someone has to decide which method to use.

You should take the time to discuss the selection of accounting methods with your Controller. Once the die is cast — in other words, after you have decided on which specific accounting methods to adopt — you have to stick with these methods year after year. For one thing, the IRS insists on this consistency in filing your annual income tax returns.

A passthrough business tax entity must file an information return with the IRS. For Chapter 2: Otherwise, it would be next to impossible to compare profit performance one year to the next. In addition to these ongoing profit-making activities, most businesses experience certain types of gains and losses now and then, which are incidental to their normal operations.

For example, your business may sell a building you no longer need at a sizable gain or loss. Or, you may lose a major lawsuit and have to pay substantial damages to the plaintiff. These special, nonrecurring events are called extraordinary gains and losses. Figure , for example, includes only one line for all sales.

You also want to know a lot more information about your sales — by customers, by products, by locations if you have more than one , by size of order, and so on. The best approach is to put detailed information in separate schedules. Our advice: How much was spent on each type of advertising? How much was spent on special rebates?

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You need to keep on top of many details about your expenses. For details, you have to read deeper. This cost was recorded in its inventory asset account at the time of purchase. When products are sold, their cost is removed from the inventory asset account and recorded in cost of goods sold expense. You can easily find the beginning and ending inventory balances in your balance sheet. This financial statement is a summary of your assets and liabilities at the beginning and end of the period.

The only real gain of information is your total purchases during the year. The question is this: What information should be included in the statement? What does the business manager need to know from each financial statement? Basically, this answer is your call; you should tell your Controller what you want in your financial statements.

For internal reporting, managers can ask for as much or as little information as they need and want. A business manager has only so much time to read and ponder the information in the financial statements he receives. The financial statements included in external financial reports that circulate outside the business are bound by standards of minimum disclosure. For example, in Chapter 3, we present a formal balance sheet that follows the rules of disclosure for external financial reporting.

How did I do during the year just ended? Did I do better or worse than last year? Did I make a profit or a loss? We use the same format we used for Figure Recall that this business is organized legally as a pass-through entity for income tax. We explain different business legal entities in Chapter 9. A loss is not good news of course.

Improving Your Profit, Cash Flow, and Solvency of bankruptcy and will have to shortly terminate the business. Figure Salaries, wages, commissions and benefits Advertising and sales promotion Depreciation Other expenses Total operating expenses Operating profit loss Interest expense Net income loss By the way, you should notice one thing in the Change column in Figure Therefore, the dollar amounts of the changes in operating profit and the bottom line are given in Figure Maintaining solvency being able to pay liabilities on time is a distinct financial function.

You have to control your solvency in order to keep your business afloat and free from interruptions by your creditors. We discuss solvency management — in good times and in bad times — in Chapter 4.

Solvency depends in part on cash flow from profit or loss. We explain the important topic of cash flow from profit or loss in Chapter 3.

Chapter 4 covers the broader function of managing solvency in. This reaction would have only worsened your situation. You should analyze the main reasons for your turnaround from a loss last year to a respectable profit in Maybe you could do more of the same and improve profit in Here are a few questions to ask yourself: Your salary and benefits are included in this amount.

Our first question is this: Of course the bottom line depends on the size of expenses deducted from sales revenue. Small businesses are unusual in one particular respect.

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In this case the loss for the year is due to your lofty compensation. Or putting it another way, your sales revenue was not enough to justify this level of compensation. But, what exactly is a reasonable amount of compensation? Perhaps you have joined a national trade association that compiles compensation information on the owners and principal managers of their members, which you could use as a benchmark.

You could troll through government statistics for small businesses put out by the Department of Commerce and the Internal Revenue Service.

These are helpful sources of information. But in the end the compensation you decide on is a fairly arbitrary amount. In many cases the person starting up a new business venture limits his or her compensation until the business turns the profit corner.

In the example presented here we assume that your compensation is reasonable in amount. Some of these nefarious tactics include the following: Diverting sales revenue directly to you rather than letting it flow through the business is called skimming.

However, the cost of products goods sold is paid by the business. The expense of the products sold is included in cost of goods sold. Therefore, gross margin is too low, and all the profit lines below gross margin are too low.

People skim sales 27 28 Part I: Be advised that the IRS is very aware that sales skimming goes on. The car is never used for business, but the business absorbs the cost of the auto.

Often, the spouse goes along on the trip. The result is that the expenses of the business are too high, and profit is too low. Suppose, for example, that you own a building and your business signs a lease agreement with the landlord you. You could set the monthly rent too high or too low so as to shift income between your building investment and your business. Setting the rent too high makes the return on your building investment look better.

Being the landlord of the building your business rents space in is but one example of how revenue and expenses can be shifted between the different business interests of a person. To save building maintenance costs, a business may violate building safety codes. You may bribe the building inspector. We can cite many more examples of illegal activities. The number of laws and regulations affecting every business — small and large — is truly staggering.

Illegal behavior has a way of eventually catching up with a business. We realize that, as economists are fond of saying, that this assumption may be heroic. In other words, our working assumption may not be entirely realistic.

But we have no other choice. No obvious answers jump off the page and grab you by the throat. A glib answer is that your sales revenue increased more than your expenses for the year. You should notice the Therefore, your gross margin benefited — jumping You increased your markups on product costs in , which helps gross margin and bottom-line profit of course. You should also notice the changes in expenses in over Are your expenses under control?

We assume that you were reasonably careful, maybe downright tight-fisted with your expenses. Looking at the sales capacity provided by operating expenses A very useful way to look at operating expenses is that these costs provide sales capacity.

For example, you rent a building for your retail, warehouse, and office space. Your retail space is 12, square feet. You can find benchmark information for sales in publications of trade associations, state business agencies, and university business research bureaus.

However, the shortfall indicates that you have enough retail space to accommodate an increase in sales next year. You employ ten full time people — salespersons, yourself, office staff, a warehouse worker, and a truck driver.

Your workforce provides the people power to make and support sales. Sales revenue pays the costs of your employees. This point goes back to your basic business model — to sell a volume of products at high enough markups over cost to cover your operating costs. Your basic pricing policy is to mark up product cost to earn 45 percent gross margin on sales revenue.

Your markup on cost is about 82 percent: Also, you have a lot of marketing and business overhead costs to pay, not to mention interest expense. The small gap between your benchmark annual sales revenue and your actual annual sales revenue could signal that stepping up sales volume next year means that you may have to hire another person or two.

You may ask where we got the two benchmarks just explained — annual sales per square foot of retail space and annual sales per employee. You better darn well know these two benchmarks for your line of business. You can find this information from trade association publications for your industry, from talking with bankers, CPAs, and business consultants, and from statistics for small businesses published by the Department of Commerce.

You can talk with other business owners in the same line of business at weekly service club meetings and at local Chamber of Commerce meetings. How much sales bang should you get for your marketing buck? There are no handy yardsticks Chapter 2: Nevertheless, you should try to develop a benchmark to judge this expense.

We suggest that you look to data published by the trade associations and talk with other business managers in your line of business. Customers often indicate whether they have responded to your advertising and sales promotions.

You can watch the sales response to special advertising and promotion campaigns. You might even hire a marketing consultant. In analyzing profit, you should understand how expenses behave relative to sales revenue. Some expenses are higher when sales are higher and lower when sales are lower. These are called variable expenses.

In the business example see Figure , you pay your sales staff 5 percent commission on sales its make. The sales commission is a good example of a variable expense. Packing and shipping costs vary with the total quantity of products sold. On the other hand, many expenses are relatively fixed in amount for the year.

These costs remain the same whether sales are high or low. As you may guess, these expenses are fixed. For example, you sign a building lease for the coming year; the monthly rents are a fixed expense. You buy a computer system. The annual depreciation charged off is a fixed expense. Most employees are paid a fixed amount of wages or salaries. Employee compensation is a fixed cost for the year, unless you lay off someone or change the number of hours worked. The annual fixed expenses of many small businesses are a large part of their total operating expenses.

Cost of goods sold expense varies with sales revenue. In other words, when sales go up, this expense goes up; when sales go down, this expense goes down.

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Selling additional units at the higher sales prices pushed up your sales revenue by a larger percent than the increase in cost of goods sold at the same product costs.

Alternatively, a business may have to reduce its markups by cutting sales prices even though its product costs remain the same. Selling additional units at the lower markups would cause sales revenue to increase by a smaller percent than the increase in cost of goods sold.

Your Controller can put your operating expenses in two piles — fixed and variable.

Depreciation expense is a fixed cost; a certain amount of depreciation expense is recorded each year regardless of the actual sales volume in the year. The annual compensation of the janitor is a fixed cost. Sales commissions are a prime example of a variable cost. The segregation between fixed and variable costs is important in analyzing past profit performance and in developing plans for improving profit in the future.

The number of expense lines would vary from business to business. Of course, your bottom-line profit or loss for each year is the same as in Figure Contribution margin equals sales revenue minus all variable expenses. In other words, contribution margin is profit before fixed expenses are deducted. In this example, the contribution margin equals In other words, in , you had 37 cents from each dollar of sales for covering your fixed expenses, compared with only Cost of goods sold Operating costs Total variable expenses Contribution margin Fixed expenses: You probably have heard about breakeven.

We say mythical for two reasons. Second, the breakeven point is just an estimate of what would happen if sales revenue were a certain amount and expenses behaved exactly as predicted. Nevertheless, the breakeven point is a valuable point of reference for profit analysis. Determining the breakeven point requires that you, or more accurately that your Controller, distinguish between your fixed and variable operating expenses.

Cost of goods sold is a variable expense. Generally, interest expense is treated as a fixed expense for purposes of breakeven analysis. The breakeven point is computed as follows: Alternatively, you needed a contribution margin ratio higher than In , you made a profit for the year, so you know that you exceeded your breakeven sales level for the year.

Pay close attention to your contribution margin ratio as a percent of sales revenue for Your contribution margin ratio in improved to 37 percent, which is a marked improvement over the Why did your contribution margin ratio increase in ? You were able to improve your markup.

Notice from Figure that your sales revenue increased This news is really good. You sold 20 percent more volume at higher sales prices, which is no small accomplishment. Perhaps you had underpriced your products in and remedied this problem in Breakeven analysis is important because it focuses attention on the incremental, or marginal profit earned by additional units sold.

It focuses attention on fixed expenses, which are like an albatross hanging around the neck of your business. The bulk of these fixed operating costs are salaries and wages. This amount also includes depreciation, rent, licenses and fees, and several other costs. Interest is a fixed expense. On the other hand, fixed costs buy sales capacity — the space and workforce to make sales. For one thing, in the example in Figure , your profit is only 3 percent of annual sales revenue, and the normal profit for your industry is in the 7.

For another thing, your relatively small profit for the year severely limited the amount of cash distribution from profit to you and the other owners of the business. Now comes the hard part: How are you going to improve profit next year? Basically, your options for improving profit boil down to four areas: Through a combination of sales price increases, product cost decreases, and a richer mix of sales, improve your overall markup ratio on sales revenue. Sell new products and sell more units of old products.

Scale down the cost per dollar or the cost per unit of making sales. The most realistic ways to improve profit are found mainly in the first two options — increasing markup and sales volume.

Most operating costs are victims of irresistible cost inflation pressures.

It goes without saying that a small business manager should ruthlessly scrutinize all operating costs and weed out wasteful expenditures. In our experience, most small business managers though not all are pretty good at expense control. Therefore, we concentrate on improving your markup and increasing sales volume. These two paths are most realistic for stepping up your profit performance. A very useful technique for analyzing profit-improvement alternatives is to prepare what-if scenarios for next year.

What if you sell 10 percent more 35 36 Part I: What if your markup ratio improves to 40 percent next year? This approach is quite practical using the Microsoft Excel spreadsheet program. Using a spreadsheet program takes the drudgery out of the process. Your profit performance is the point of reference for testing different scenarios for improving profit next year. Improving markup Recall that your basic business model is to sell a volume of products at adequate markups over their costs to cover your marketing and operating expenses in order to generate satisfactory profit after interest expense.

In , your markup gross margin equals 42 percent refer to Figure for data: Therefore, you fell short of this goal in In other words, you discounted sales prices for certain customers.

To earn 45 percent gross margin on sales revenue, your cost of goods sold expense has to be 55 percent of sales revenue. Also, all other factors are held the same. In other words, we isolate on the sales price factor; this is the only profit factor that is changed in the what-if scenario.

You pay your sales staff 5 percent commissions on sales, so the larger amount of sales revenue makes this expense larger. Increasing your sales prices 5. This example illustrates the power of even relatively small changes in sales prices on the bottom line. If you could have sold products for just 5. We recognize, of course, that in many cases customers are very sensitive to sales prices. Even a seemingly small sales price increase could lead to a serious decline in demand.

Our purpose in showing the higher sales prices scenario is to demonstrate the powerful effect of increasing sales prices on the bottom line. Improving Your Profit, Cash Flow, and Solvency Improving sales volume Suppose that you had sold 10 percent more volume in than you actually sold. For every units actually sold, what if you had sold units?

Presume that your sales mix, the proportion of each product sold in total sales volume, would have been the same. How much higher would your profit be in this scenario?

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Can you hazard a guess? Well, not really; you have to crank the numbers. Sales revenue, cost of goods sold expense, variable operating expenses, and contribution margin all increase 10 percent.

The additional amount of sales revenue causes sales commissions expense to increase proportionally, which is the only variable operating cost in the business example shown in Figure A business may have other variable operating costs that depend on the number of units sold: